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Procurement of Explosive Ordnance for the Australian Defence Force (Army)

Tabled Performance audit report

Procurement of Explosive Ordnance for the Australian Defence Force (Army)

Published

Wednesday 17 May 2006

Report number

40 of 2005-2006

Portfolio

Defence

Entity

Department of Defence; Defence Materiel Organisation

The objective of the audit was to examine processes used by Defence and the DMO to procure explosive ordnance for the ADF, with an emphasis on Army requirements. The audit reviewed the extent to which the DMO effectively translated the explosive ordnance requirements of the ADF, and particularly of Army, into procurement and through life support arrangements.

Summary

Background

1. The procurement and through life support of explosive ordnance1 is a complex process involving extended lead times and the commitment of significant levels of resourcing. As at 30 June 2005, the recorded value of Defence's explosive ordnance exceeded $2 billion. During 2004–05, the Defence Materiel Organisation 2(DMO) was allocated an explosive ordnance sustainment budget, for all three Services, of $183.5 million of which it spent $144.2 million. This budget included $62 million to address previous logistic funding shortfalls.

2. Major Capital Equipment Projects also fund the procurement of explosive ordnance in support of new weapons platforms being acquired. In addition to recurrent funding, Project JP 2085 is intended to increase reserve explosive ordnance stockholding levels. Approved in 2003, Phase 1B of the Project has a budget of $202 million to be expended over five years commencing in 2003–04. Later phases of the Project are estimated to cost between $500 million and $700 million.

3. Defence advised the ANAO that during a period of substantial organisational change the operational tempo for the Australian Defence Force 3(ADF), and particularly Army, have increased substantially, commencing with the deployment to East Timor through to the current day deployments to Iraq and Afghanistan. Consistent with the increased ADF tempo, explosive ordnance sustainment procurement has increased from a baseline of around $120 million per annum in 2001–02, to nearly $250 million per annum in 2002–03 and 2003–04. Defence considers that the requirement to meet increased operational demands has contributed to at least some of the sub-optimal practices outlined in this audit report.

DMO Procurement

4. The DMO is responsible for the procurement of explosive ordnance to fulfil requirements identified by the Services 4 for operating stock, and the Capability Development Group for new Capital Equipment Projects and Project JP 2085 5. The DMO provides advice to the Services and the Capability Development Group on how endorsed explosive ordnance capability requirements may be achieved using available funding, current stockholdings and supply chain dynamics.

5. In May 2004, following the 2003 Defence Procurement Review, the Guided Weapons and Explosive Ordnance (GWEO) Branch6 was established within the Electronic and Weapon Systems Division of the DMO. The GWEO Branch is responsible for explosive ordnance procurement and management functions including the acquisition of explosive ordnance and associated through life support.

Suppliers of explosive ordnance

6. In 1999, the Government sold its shareholding in ADI Limited. The Mulwala Agreement and the Strategic Agreement for Munitions Supply (SAMS Agreement) now guarantee the future of ADI as the principal domestic explosive ordnance supplier to the DMO. Both of these agreements were renegotiated concurrently with the sale of ADI. 7

7. The Mulwala Facility, in southern New South Wales, manufactures propellants and high explosives for use in the manufacture of explosive ordnance for the ADF8. The Facility is owned by Defence and managed by ADI. Under the Mulwala Agreement the DMO pays ADI in the order of $31 million annually to operate the Facility 9. The cost of propellant and high explosive purchased by the DMO is additional to that payment. Significant expenditure has also been committed towards modernising and addressing environmental issues associated with the Facility. At the time of audit fieldwork the DMO was seeking and evaluating tenders for the redevelopment of the Mulwala Facility.

8. The SAMS Agreement relates to the Benalla Facility, which manufactures munitions primarily for the ADF 10. In addition to the cost of any explosive ordnance procured by the DMO under the SAMS Agreement, the DMO pays the supplier some $50 million annually to maintain the capability to manufacture munitions at the Benalla Facility until at least 201511.

9. Explosive ordnance is also procured by the DMO from overseas suppliers using three key methods. These are directly from overseas suppliers; using ADI as an intermediary; and from the US Government under Foreign Military Sales (FMS) arrangements. In some instances, explosive ordnance is procured by ADI from overseas suppliers, where the provisions of the SAMS Agreement provides exclusive rights to supply certain types of ammunition.

Audit approach

10. The objective of the audit was to examine processes used by Defence and the DMO to procure explosive ordnance for the ADF, with an emphasis on Army requirements. The audit reviewed the extent to which the DMO effectively translated the explosive ordnance requirements of the ADF, and particularly of Army, into procurement and through life support arrangements.

Overall audit conclusion

11. The procurement of explosive ordnance involves significant levels of expenditure and has implications for the overall preparedness of the ADF. The ANAO considers that extensive improvements are required within Defence, and the DMO, to better align explosive ordnance procurement processes with ADF preparedness requirements to train, and meet contingency requirements should they eventuate.

12. The ANAO identified that management action is required in respect of the following areas:

Procurement planning: Processes to translate identified explosive ordnance demand into inventory management and procurement plans were not clearly defined, or adequately documented between Defence and the DMO. The explosive ordnance requirements for Major Capital Equipment Projects can involve significant expenditure; however, these requirements were inadequately costed through the approval process for Project Land 19 Phase 6–Short Range Air Defence Weapon System and Project Land 907–Main Battle Tank Replacement.

Financial management: Weaknesses in procurement planning for explosive ordnance have contributed to a poor alignment between explosive ordnance budgets and actual expenditure. In 2002–03 and 2003–04, the DMO initiated a number of prepayments that were in excess of 90 per cent of contract values to bring forward expenditure. In 2004–05, approximately $47.8 million in explosive ordnance funding was returned to the Defence budget. As at June 2005, $202 million out of the $684 million in Defence prepayments, related to explosive ordnance.

Inventory management: The management of the serviceability of explosive ordnance was such that in October 2005, $1.04 billion, or approximately half the total explosive ordnance inventory, was classified as other than ‘serviceable'12 .

Safety and suitability for service assessments: In 2000, the remediation of legacy explosive ordnance 13 was identified by Defence as a significant long term issue requiring resolution. Measures to resolve the legacy explosive ordnance issue have achieved limited improvement. The continued procurement of explosive ordnance without, in some cases, being able to secure technical data to support safety and suitability for service assessments has compounded these issues and exposed Defence to significant risk.

Contract management: Management of the SAMS Agreement for the domestic manufacture of explosive ordnance has required the DMO to initiate a remediation programme in mid 2005, given the significance to Defence capability and the level of associated expenditure. The DMO has not maintained an up to date version of the SAMS Agreement since 2000, and inadequate documentation surrounding amendments to the contract constrains the capacity of the DMO to manage the Agreement.

13. These issues require the effective implementation of long term remediation strategies. Prior to and during the course of the audit Defence and the DMO recognised a number of weaknesses in the management processes associated with explosive ordnance. A number of remediation activities have been initiated to address these weaknesses. The ANAO considers this to be a positive outcome acknowledging that these are initial phases in a process of ongoing reform.

Key findings

Forecasting demand (Chapter 2)

14. Project JP 2085, which is classified by Defence as a Major Capital Equipment Project, was not subject to the full two pass approval process 14 having only being considered by Government on one occasion. The ANAO considers that documentation of the Project could be improved particularly with respect to overall procurement planning and identifying the capabilities required of new types of ammunition procured using Project funds. Weaknesses in planning processes for initial expenditure against Phase 1B resulted in Project funding not being aligned with standard contractual payment requirements for explosive ordnance. Consequently, in 2003–04 the DMO initiated several large prepayments which represented significant proportions of associated contract values in order to expend funds.

15. The ANAO identified that processes between the DMO and Army to translate operating and reserve explosive ordnance stock requirements into procurement and inventory management strategies required improvement. In December 2005, Defence indicated that the Secretary of Defence and the Chief Executive Officer of the DMO had directed that a more comprehensive and contemporary policy on explosive ordnance should be developed to complement reserve stockholding policy.

16. The ANAO noted that weaknesses exist in the planning process for the acquisition of explosive ordnance for new weapons platforms, including the identification and costing of explosive ordnance requirements. The ANAO identified that Major Capital Equipment Projects including Land 19 Phase 6 Short Range Air Defence Weapon System and Land 907 Main Battle Tank Replacement were experiencing difficulty in funding the procurement of explosive ordnance within the approved Project budgets. A combination of Project funds, recurrent explosive ordnance funding and JP 2085 funding were being used to procure explosive ordnance required by these weapons platforms.

Operational availability of explosive ordnance (Chapter 3)

17. In March 2005, the DMO identified that approximately one-third of the $928 million in explosive ordnance that was classified as other than ‘serviceable', could not be made serviceable. The serviceability of one-quarter of this figure was yet to be determined. The ANAO identified that serviceability issues have impacted on the availability of certain types of explosive ordnance to Army. In October 2005, Defence advised the ANAO that the value of other than ‘serviceable' inventory had increased to $1.04 billion 15.

18. The existence of explosive ordnance without a complete safety and suitability for service assessment 16 increases the risk in handling inherently hazardous materiel. In 2002, the DMO recognised that there was a need to take urgent action to address the legacy explosive ordnance issue. A DMO report in December 2002 identified that it would take between five to 14 years to address all legacy explosive ordnance issues. Overall, there has been an absence of progress in addressing these legacy explosive ordnance issues since 2003, other than in the area of airdrop 17 assessments. In October 2005, a scoping study for a project to resolve legacy explosive ordnance issues was finalised by the DMO.

19. The ANAO identified several instances, involving significant expenditure, where the DMO has not secured technical data at the time of the procurement to enable a safety and suitability assessment, thereby compounding the legacy explosive ordnance issue. In some circumstances, the requirement to expend funds has been given priority over securing technical data through the contracting processes. Obtaining technical data can be more difficult to achieve after a contract has been let.

20. The ANAO considers that the availability of technically qualified personnel is limiting the capacity to address serviceability and legacy explosive ordnance issues. Factors identified as contributing to these personnel deficiencies were the loss and redistribution of technically qualified military personnel as a consequence of the rationalisation of the explosive ordnance function from the Services into JALO in 1998. In May 2005, the DMO commenced developing a workforce renewal strategy to address workforce planning and training issues associated with an ageing workforce. This strategy was finalised in October 2005.

Domestic supply (Chapter 4)

21. The DMO has not updated the SAMS Agreement to incorporate Agreement Change Proposals since 2000. In other instances, changes to processes outlined in the Agreement were agreed between the DMO and the Supplier, but not reflected in Agreement Change Proposals.

22. The ANAO noted that annual reviews of the costs associated with the SAMS Agreement were not being conducted on a timely basis and mechanisms to record this data were not in accordance with the Agreement. The Agreement provided that a performance target for costs would be set in 2003. This had not occurred at the time of ANAO fieldwork in late 2005.

23. The SAMS Agreement stipulates when the DMO is required to submit Requests for Quotations and orders for a given financial year. The timing of key ordering processes in the SAMS Agreement was not reflected in the Materiel Sustainment Agreement (MSA) for explosive ordnance between Army and the DMO. The DMO advised that the MSA was the subject of ongoing review to identify improvements.

24. The ANAO reviewed a number of Agreement Change Proposals to alter the capability of the Benalla Facility. The ANAO noted that the DMO did not undertake detailed cost investigations or financial analysis prior to accepting these proposals. Other weaknesses surrounding acceptance of these Agreement Change Proposals included inadequate long term forecasting of demand and inadequate liaison between the DMO and Army. In August 2005, Defence commissioned a review of the SAMS Agreement to address DMO management concerns and issues identified by the ANAO.

25. At the time the SAMS Agreement was renegotiated in 1999, the contract was estimated to be valued at $591.1 million, payable by Defence over the initial term of the Agreement18. This was based on an initial investment of $176.8 million. The arrangement has the characteristics of a finance lease under the Australian Accounting Standards given that it is, amongst other matters, effectively non-cancellable and has a bargain purchase clause where the DMO can buy the Benalla Facility for one dollar in 2015. A finance lease effectively transfers all the risks and benefits incidental to ownership of the leased non-current asset from the lessor (ADI) to the lessee (DMO). Under an operating lease, the lessor effectively retains substantially all such risks and benefits.

26. The Acting Defence Chief Finance Officer advised the ANAO in October 2005 that the Department had concluded that the SAMS Agreement was a lease that should be treated as an operating lease. This matter is the subject of ongoing dialogue between the ANAO and Defence. In March 2006, Defence advised that it was reviewing the accounting treatment of the SAMS Agreement as part of the 2005–06 financial statements process.

Overseas supply (Chapter 5)

27. A November 2004 DMO report identified weaknesses in contract management arrangements in the GWEO Branch. Subsequent internal reviews confirmed the need for improvement in contract management arrangements within the GWEO Branch. Issues identified included limited awareness and use of key Defence procurement policy documents and unfamiliarity with financial delegations and procurement approval requirements. ANAO audit fieldwork supports these findings. In mid to late 2005, the DMO initiated a number of measures to improve contract and financial management processes within the GWEO Branch.

28. During fieldwork the ANAO identified a number of instances where the DMO had effectively outsourced explosive ordnance procurement management to ADI. This outsourcing occurred under a standing offer arrangement first executed in 1999 and amended in mid 2003. The DMO did not obtain legal advice on the standing offer arrangements prior to mid 2005. The standing offer provided indemnities inconsistent with both Defence and Department of Finance and Administration guidelines. In mid 2005, legal advice was obtained by the DMO that resulted in the decision being taken to discontinue the use of the standing offer in July 2005.

Financial management (Chapter 6)

29. In recent years, there has been a poor alignment between budgeted and actual explosive ordnance expenditure for both recurrent and Project JP 2085 expenditure. In 2002–03, the DMO was allocated additional funding late in the financial year, which enabled expenditure on explosive ordnance to exceed the original annual budget by $110 million. To expend these additional funds, within the financial year, the DMO initiated substantial prepayments. For the bulk of the prepayments no explicit benefit or discount was obtained. In acquiring one tranche of Bolide missiles involving a 90 per cent prepayment on a $26.6 million contract, the DMO negotiated a series of benefits including additional missiles and accelerated deliveries to justify the prepayment 19. A number of these benefits did not eventuate.

30. The DMO also made significant prepayments late in 2003–04 to achieve expenditure of sustainment funding and Project JP 2085 Phase 1B funding. For Project JP 2085 the DMO initiated prepayments, totalling $44.9 million out of a budget of $50.1 million. The largest proportion of JP 2085 expenditure was a 90 per cent prepayment ($33.3 million contract) for another tranche of Bolide missiles. In several instances, 100 per cent prepayments were made for explosive ordnance being supplied under the provisions of the SAMS Agreement. Under the terms of the SAMS Agreement, milestone payments normally occur during the period from acceptance of quotation to actual delivery. The DMO could not provide documentation to justify these prepayments and the ANAO questions the validity of prepayments for a milestone based contract arrangement.

31. Expenditure forecasts for 2004–05 indicated that a large proportion of the explosive ordnance budget would be expended in June 2005. However, these forecasts were adjusted in March 2005 resulting in the return of $47.8 million in explosive ordnance sustainment funding to the Defence budget. This figure represented one–quarter of the total recurrent budget for explosive ordnance and indicates the need for improvement in budget estimation and related procurement planning processes. The DMO advised that during 2004–05 the DMO recognised that substantial prepayments had been made without adequate justification and indicated that the return of $47.8 million in 2004–05 was in part as a result of imposing additional business rules for prepayments.

32. A 2005 Defence internal audit into the recording of prepayments by the GWEO Branch confirmed that a discrepancy existed between the Resource and Output Management and Accounting Network (ROMAN) and the Computer System for Armaments (COMSARM). This discrepancy resulted in a significant understatement of the value of explosive ordnance prepayments as at April 2005. Consequently, the calculated value of explosive ordnance prepayments was increased from $103.4 million 20 to $207.5 million. In mid 2005, the DMO initiated a number of measures to improve accountability processes for prepayments.

Recommendations

33. The ANAO has made 15 recommendations to improve management approaches associated with procurement planning; financial management; inventory management; safety and suitability for service assessments; and contract management.

Agency response

34. The Department of Defence provided a response on behalf of DMO and Defence. Defence and the DMO agreed with all 15 recommendations contained in the report. An extract from the response stated that:

The Department of Defence's management of explosive ordnance for the Australian Defence Force has undergone significant review and reform since 1998 when the management of explosive ordnance for all three Services was brought under a single entity. Initial reforms centred on improving technical integrity of decision making and data management which are ongoing. More recent reforms have included changes to financial, business and logistics management, and the remediation of explosive ordnance requirements definition processes. The changes have played an important role in improving the overall management of the procurement of explosive ordnance for the Australian Defence Force. Much of the remediation work was commenced by Defence prior to and during the ANAO audit.

The 15 recommendations arising out of the ANAO report are consistent with the broad approach adopted by Defence regarding the reform of the procurement of explosive ordnance for the Australian Defence Force. The ANAO acknowledges Defence's efforts throughout their report into the Procurement of Explosive Ordnance for the Australian Defence Force (Army). Defence recognises the importance of ongoing assurance and continuous improvement activity in relation to the management of the procurement of explosive ordnance for the Australian Defence Force.

2 On 1 July 2005, the DMO was established as a Prescribed Agency under the Financial Management and Accountability Act 1997 thereby making the Chief Executive of the DMO responsible for the financial management of the agency. In line with this change, this report refers to the DMO when issues are specific to that agency.

3 The term ADF is used within this report to describe the military elements of the Department of Defence.

4 Services include Army, Navy and Air Force.

5 Operating stocks are those that Army regard as necessary to fulfil peacetime training requirements and are generally funded through recurrent funding or funding associated with the introduction into service of new weapons platforms. Reserve stocks are those held in addition to operating stocks for possible contingency requirements, which may be funded through recurrent funding, by funding derived from Project JP 2085, or funding associated with the introduction into service on new weapons platforms.

6 The functions assigned to the GWEO Branch were previously conducted within the DMO's Joint Ammunition Logistics Organisation (JALO). An outcome of the Defence Procurement Review was the reallocation of JALO functions between the DMO and Defence.

7 A Multi-Party Deed was executed in 1999, which provides security to the financiers of the purchaser of ADI (Transfield Thomson-CSF Investment Pty. Ltd.).

8 The physical facility was not included in the sale of ADI due to a range of occupational health and safety, environmental and modernisation issues.

9 In 2005, this comprised a capability payment of $25.8 million and approximately $5 million per annum paid to ADI for the repairs and maintenance to plant, buildings and infrastructure associated with the capability being a Government owned facility. The cost of modernisation and environmental rectification of the Mulwala Facility is in addition to this amount.

10 ADI advised the ANAO that the Australian Government, after numerous reviews, has confirmed the need for a strategic self reliant munitions manufacturing capability to provide high consumption or specialist munitions to the ADF. The Benalla Facility was sized to provide the annual training requirement on a single shift basis with surge requirements met by multi-shift production.

11 Approximately $22.8 million of the capability payment under the SAMS Agreement passes directly from ADI to the financiers of the purchase of ADI from the Government.

12 Other than ‘serviceable' explosive ordnance comprises three broad categories which are ‘repairable'; ‘pending'; and ‘non-repairable'.

13 Legacy explosive ordnance is ordnance currently in ADF service, for which there is no clearly identifiable audit trail in relation to the associated safety and suitability for service assessment.

14 The two stage decision making process for Major Capital Equipment Projects, directed by Government consists of first pass approval at which Government considers alternatives and approves a capability development option(s) to proceed to more detailed analysis and costing; and second pass approval at which Government agrees to fund the acquisition of a specific capability system with a well defined budget and schedule.

Defence advised the ANAO that Project JP 2085 Phase 1B was approved by Government in February 2004 and at that time the two pass approval process was not embedded in the Cabinet Handbook. The ANAO notes that the Strengthened Two Pass Approval process was recommendation 3 of the 2003 Defence Procurement Review which was adopted by Government in September 2003.

15 The DMO advised that a recent withdrawal from service of missiles and related items awaiting disposal, was skewing these figures upwards temporarily.

16 The assessment of safety involves an appraisal of the inherent freedom from explosive hazard of the item design; evaluating the inherent risk on deploying the item in prescribed environments throughout its anticipated service life; and consideration of the acceptability of this risk in meeting the operational requirement. The assessment of suitability for service requires objective evidence that the item or associated elements of a weapon or equipment are capable of functioning as designed and that the service environments encountered throughout the service life will not degrade the functioning to an unacceptable level.

17 Airdrop relates to the delivery of equipment, including explosive ordnance, from the air by suitable aircraft.

18 During the initial term of the Agreement, which expires in 2015, the rate of return is derived by adding an average ten year bond rate to a constant margin for risk.

19 The Bolide is a third-generation version of the RBS 70 missile, which is primarily used by Army for very low-level air defence.

20 In October 2005 Defence advised the ANAO that this adjustment had been revised to $98 million.